CF-CS3

FIN 6301, Corporate Finance 1

Course Learning Outcomes for Unit III Upon completion of this unit, students should be able to:

3. Apply the valuation principle. 3.1 Explain the difference between stand-alone risk and risk in a portfolio context. 3.2 Explain the distinction between a stock’s price and its intrinsic value.

8. Analyze the risk and return of a financial decision.

8.1 Describe how risk aversion affects a stock’s required rate of return.

Course/Unit Learning Outcomes

Learning Activity

3.1

Unit Lesson Chapter 6, pp. 243-277 Chapter 7, pp. 295-319 Chapter 8, pp. 343-352 Unit III Case Study

3.2

Unit Lesson Chapter 6, pp. 243-277 Chapter 7, pp. 295-319 Chapter 8, pp. 343-352 Video Segment: “Understanding the Stock Market” Unit III Case Study

8.1

Unit Lesson Chapter 6, pp. 243-277 Chapter 7, pp. 295-319 Chapter 8, pp. 343-352 Unit III Case Study

Required Unit Resources Chapter 6: Risk and Return, pp. 243–277 Chapter 7: Corporate Valuation and Stock Valuation, pp. 295–319 Chapter 8: Financial Options and Applications in Corporate Finance, pp. 343–352 In order to access the following resource, click the link below. Meridian Education (Producer). (2011). Understanding the stock market (Segment 6 of 9) [Video]. In Saving

and investing. https://libraryresources.columbiasouthern.edu/login?auth=CAS&url=http://fod.infobase.com/PortalPla ylists.aspx?wID=273866&xtid=43785&loid=116639

Understanding the Stock Market (Segment 6 of 9) Video Transcript

UNIT III STUDY GUIDE

Stocks and Options

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Stocks A stock, which is also called share or equity, is a type of security that indicates ownership—in terms of assets or earnings—within a corporation. The two main types of stocks are common and preferred. The main difference between the two is voting rights. Common stockholders have voting rights, whereas preferred stockholders do not. Preferred stockholders receive their dividends earlier than common stockholders, and they have priority in the liquidation of a company should it go bankrupt. To illustrate the differences in common and preferred stocks and how one can be more appropriate in a given situation than the other, consider the following case. Jodie is a widow who has extra money that she is willing to invest in order to gain a little income. Even though she obviously wants to gain more money than what she had initially invested, she is not daunted by the possibility that the value of her share could be lower than her initial investment. She is willing to take the risk and not see fixed income if there are more opportunities for potential gains in the long-term. Given Jodie’s financial situation, preferred time frame, and investment goals, she is likely to be more comfortable with being a common stockholder.

Advantages and Disadvantages Involved in Stocks Stocks have the advantage of higher potential earnings, especially when compared to the earnings that can be gained through bonds. Another advantage of stocks is the ease with which they can be bought through brokers, through financial planners, or online. By investing in stocks, the investor has multiple ways of earning money. Investors can buy low and then sell high, and they can purchase stocks of companies that pay dividends. Finally, stocks have historically beaten inflation, with an annual average return of 10% when compared to an annual inflation rate of 3.2% (McMahon, 2018). Even though the potential for gains is high, stocks are a riskier type of investment because people can lose all of their investments or significantly lose the value price of their initial investments when a company performs poorly. Another possible disadvantage of stocks is that a lot of research is often necessary in order to determine which company is more likely to be profitable and less likely to perform poorly. This research also entails being able to read financial statements and annual reports and follow the stock market and current events as they pertain to companies being considered for investment. Another disadvantage when investing in stocks is the volatility of the market wherein stock prices can go up or go down within a day. Even though stocks can be sold easily, investors have the potential to lose money if they need to take out their money at a time when the stock prices are down. To illustrate how a person may weigh the advantages and disadvantages of investing in stocks, consider the following case. Barbara is exploring how she can use stocks to maximize the $250,000 savings that she accumulated over 15 years of working as a teacher. She has no other savings other than that money, and she plans to retire within about five years. She is relatively financially savvy, which means that she knows how to read financial reports and is up-to-date with the current stock market trends and the current events concerning various companies. When she consulted with a financial planner, she was advised to invest her money in safer types of investments such as bonds. Given her current situation, it is not advisable for her to put her money in stocks because she could lose all of her life savings. Stocks are more advisable when somebody has extra money (e.g., non-retirement money, winnings from a lottery) that they are willing to lose in case something adverse happens with the stock market. Note that, generally speaking, the propensity for investment risks, such as stocks, tend to decrease as one ages because the opportunity to regain money from a loss becomes more difficult (Kim, Hanna, Chatterjee, & Lindamood, 2012). Hence, it may not be advisable to invest in stocks when one is about to retire.

Options Options belong to a larger group called derivatives, which are linked to the price of something else. Options are contracts that give an individual the right to buy or sell a stock at a specific price within a specific date. There are two types of options: call options and put options. Call options are the right to buy, whereas put options are the right to sell.

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How are options different from the more commonly understood future contracts? Option contracts are merely rights to buy or sell with no obligation involved, whereas future contracts include both the rights and the obligations (i.e., if you say you will buy on a specified date, you are legally bound to buy on that date). In option contracts, you are not legally bound to buy or sell. Below is a summary that should help you better understand the difference between call options and put options.

• Call options are like deposits for future purposes. For example, Peter wanted to have the right to buy land but only if a swimming pool was established within the area. Therefore, Peter bought a call option to the owner of the land for $200,000 for 3 years. In order to lock in the price and the right to buy that land for 3 years, Peter paid the $10,000 premium (i.e., the call option) to the owner. When 3 years have passed and the swimming pool has not been installed, this means that Peter does not want to buy the land. Peter lost the $10,000 premium, but he had no obligation to buy the $200,000 land.

• Put options are like insurance policies. For example, Lisa owned a portfolio of stocks, and she was worried that a recession could happen in 2 years. She wanted to ensure that if a recession did occur within the next 2 years that she would not lose more than 10% of the value of her portfolio. The current trading was at $2,500 in the Standard & Poor’s 500 index. She bought a put option (i.e., premium at a specific cost) that gave her the right to sell at $2,250 within the next 2 years. Within a year, the market crashed by 20%, an equivalent of $500 loss in her portfolio. However, because of her put options, she was able to sell at $2,250 even though the actual trading was at $2,000.

Uses of Options

There are many reasons why investors would choose options as a part of their portfolio. Consider the following uses of options.

• Speculation: Investors want to make a bet (often based on a gut feeling) that could lead to a higher selling price in the future. This is considered risky because it assumes that the bet is correct about the direction of the increase or decrease of something (e.g., stocks), the amount of change in the price, and the time frame when these predicted changes will occur. It takes considerable skills to correctly predict these trends. Option traders are generally more skilled in anticipating correct information compared to equity traders (Jin, Livnat, & Zhang, 2012).

• Hedging: One of the primary reasons why investors choose options is to minimize risk at a reasonable cost (i.e., premium). Options can be used as an insurance policy. For example, gold has been found to be a good hedge against stocks, particularly in extreme market conditions (Baur & Lucey, 2010). Using this empirical data, gold options can be bought as a strategy to minimize the risk of plummeting stocks.

• Synthetics: This strategy creates a position that mimics another position without controlling that other asset. This mirroring strategy can hedge positions or protect profits. For example, an at-the-money long call (i.e., the investor believes that the price will go up significantly in the future) increases the same way as 100 shares of stock in a given period of time (i.e., expiration). A synthetic long call (using the 100 shares of stock) can mimic or represent the predicted increase in prices of a long call. To disregard the risk involved in the 100 shares, a long put could be bought, leading the long put to balance the risk of 100 shares of stock to match the limited risk of a long call option.

Differences Between Options and Stocks

To illustrate the difference between options and stocks and how they work, consider the following analogies.

• Casino (trading stocks): Trading stocks is like gambling in a casino because everybody at the casino is betting against the house, which means that if everybody is incredibly lucky, everyone can win—all at the same time.

• Racetrack (trading options): Trading options is like betting at a horse racetrack, wherein each person is betting against other people with the track only getting a small percentage for providing the facilities for the betting to occur. Somebody’s win is somebody else’s loss.

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Conclusion Stocks and options are popular financial tools for investors. As discussed above, each of these has its advantages and disadvantages. It is important to understand that when you are investing in a particular stock, there are several ways to do so. Stock options are gaining momentum because investors can participate in a move without having to purchase the stock outright.

References Baur, D. G., & Lucey, B. M. (2010, April 16). Is gold a hedge or a safe haven? An analysis of stocks, bonds

and gold. The Financial Review, 45(2), 217–229. Jin, W., Livnat, J., & Zhang, Y. (2012). Option prices leading equity prices: Do option traders have an

information advantage? Journal of Accounting Research, 50(2), 401–432. Kim, E. J., Hanna, S. D., Chatterjee, S., & Lindamood, S. (2012, February 9). Who among the elderly owns

stocks? The role of cognitive ability and bequest motive. Journal of Family and Economic Issues, 33(3), 338–352.

McMahon, T. (2021, January 13). Annual inflation. InflationData.com

https://inflationdata.com/Inflation/Inflation/AnnualInflation.asp